By Louis A. Mezzullo, Esq.
Luce, Forward, Hamilton & Scripps LLP, Rancho Santa Fe, CA
Two recent cases have highlighted the continuing conflict among the courts about how to determine the appropriate discount for the so-called "built-in capital gains tax." For purposes of this commentary, the built-in capital gains tax is the potential tax on a corporation's unrealized appreciation that the corporation would incur when it disposes of its assets. The built-in capital gains tax is different than the built-in gains tax that is imposed on the unrealized appreciation of a corporation's assets held as of the date the corporation makes an S election that are sold within a 10-year period after making the S election. Courts did not agree that a built-in capital gains tax liability discount was appropriate before the repeal of the General Utilities doctrine in 1986 because it was possible to avoid a double level of tax when a C corporation was liquidated. Once it was no longer possible to liquidate a C corporation without incurring a tax on the unrealized appreciation of its assets at the corporate level, courts began to accept a discount for the built-in capital gains tax that would be incurred when valuing an interest in a C corporation. However, the built-in capital gains tax liability discount will have no affect on the value of a corporation based on either the market approach or the income/discounted cash flow approach.
Two approaches have been accepted by the courts in determining the appropriate amount of the discount: the dollar-for-dollar approach and the present value approach. Under the dollar-for-dollar approach, the potential tax on the corporation's unrealized appreciation as of the valuation date (in the case of an estate, the date of death or the alternate valuation date) is subtracted from the value of the corporation. Under the present value approach, an assumption is made as to the turnover rate of the corporation's assets, which also defines the holding period for the assets. The tax on the unrealized appreciation in the corporation's assets as of the valuation date is calculated based on the date the assets would be sold, using the estimated turnover rate or holding period. The present value of the tax is then determined using an assumed discount rate. A variation, accepted by some courts, is to include the potential tax on the estimated additional unrealized appreciation after the valuation date using an assumed interest or appreciation rate, in some cases the same rate that was used for determining the present value of the tax liability.
Estate of Litchfield v. Comr., T.C. Memo 2009-21, involved two corporations. The first corporation, LRC, owned farmland and marketable securities, and a subsidiary that owned and operated a public grain elevator and that sold to farmers crop insurance and services such as pesticide and fertilizer applications. The decedent, who owned 43.1% of the stock, died on April 17, 2001. The corporation had made an S election on January 1, 2000. The decedent owned 22.6% of the second corporation, LSC, which owned marketable securities, and partnership and other equity investments. The corporation had not made an S election, because its income was passive, which would have caused the termination of the S election after three years.
The IRS and the estate agreed on the net asset value of the corporation and that discounts were appropriate for the built-in capital gains tax liability, lack of control, and lack of marketability. Both used a present value approach in determining the appropriate discount for the potential built-in capital gains tax of both corporations. Under this approach, as discussed above, one assumes an estimated turnover rate or holding period, determines the capital gain tax liability that would be paid as the assets are sold, and discounts the tax back to the valuation date. However, the IRS asserted a 2% discount for the potential built-in capital gains tax liability in LRC, while the estate asserted a 17.4% discount, and the IRS asserted an 8% discount for the potential capital gains tax in LSC, while the estate asserted a 23.6% discount. The IRS used a holding period of 53.76 years for LRC and 29 years for LSC and did not include in its calculation for LRC any capital gains taxes that would occur after the 10-year period when the corporation would no longer recognize the built-in gains tax under §1374. In addition, the IRS did not take into account appreciation after the valuation date. The court accepted the estate's holding period of five years for LRC and eight years for LSC. The court also agreed that future appreciation should be taken into account. Thus the court accepted the estate's 17.4% discount for LRC and 23.6% discount for LSC.
The court in a footnote noted that a dollar-for-dollar approach for determining the discount for built-in capital gains tax liability was used in two prior cases, Estate of Jelke v. Comr., 507 F.3d 13117 (11th Cir. 2007), vac'g, T.C. Memo 2005-131, and Estate of Dunn v. Comr., 301 F.3d 339 (5th Cir. 2002), rev'g T.C. Memo 2002-12. As mentioned above, under the dollar-for-dollar approach, the discount for the built-in capital gains tax liability is equal to the tax that would be paid if the corporation sold the appreciated assets on the valuation date. Because the estate's expert did not assume that the assets of the corporations would be sold on the valuation date and the estate did not ask the court to apply a dollar-for-dollar valuation discount for the estimated built-in capital gains tax liability, it did not need to decide whether such an approach would be appropriate in another case where that argument is made.
Jensen v. Comr., T.C. Memo 2010-182, involved a corporation that owned improved real estate that was used as a summer camp for girls. The decedent owned an 82% interest in the corporation. In determining the discount for the built-in capital gains tax liability, the estate used the dollar-for-dollar approach. The IRS used the closed-end mutual funds to determine the discount. It also asserted that the built-in capital gains tax could be avoided by either making an S election or engaging in a §1031 tax-free exchange. The court did not agree that the decedent's interest in the corporation was comparable to closed-end mutual funds and noted that there were limitations on the ability of either of the methods suggested by the IRS to avoid the built-in capital gains tax. The court also rejected the estate's dollar-for-dollar approach and used the present value method for determining the appropriate discount. The court applied discount rates of 5% and 7.75% compounded annually over 17 years to the built-in capital gains tax liabilities, which included assumed future values based on the same discount rates, and a 40% combined federal and state income tax rate. The range of discounts the court arrived at were actually higher than the estate's discount based on the dollar-for-dollar approach, and therefore, the court accepted the estate's discount.
Where does the case law leave us with regard to the built-in capital gains tax liability issue? Certainly the dollar-for-dollar approach adopted by the Fifth and Eleventh Circuits is simpler to apply. The present value approach involves assuming turnover rates or holding periods, a discount rate for determining the present value of the tax liability, and perhaps an interest rate for determining the amount of future appreciation. It may be that an appraiser in a circuit other than the Fifth or the Eleventh would be prudent to compute the built-in capital gains discount using both methods, and then applying whichever method provides the greatest discount.
For more information, in BNA's Tax Management Portfolios, see Mezzullo, 831 T.M., Valuation of Corporate Stock, and in Tax Practice Series, see ¶6290, Valuation — Generally.
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